The myth of yuanâ€™s rise - Explained

In moments of extreme boredom, watching grass grow â€“ or paint dry â€“ can prove an engaging pastime. However slow the process, it has a certain ennui-defeating appeal to it. Up until recently, watching the Chinese currency, the renminbi (or the yuan), appreciate against the US dollar to which it maintains a quasi-peg, had much the same effect.

But since earlier this month, when the undervalued yuan, which maintains a quasi-peg to the US dollar, appreciated by 0.8 percent against the dollar, it has had commentators going into paroxysms of delirium and talking of a â€œmini revolutionâ€ under way in China.

Taken with a recent Chinese media report which claimed that the time was â€œripeâ€ for China to widen the yuanâ€™s trading band against the US dollar, itâ€™s had analysts feverish with excitement about the day when â€œthe almighty renminbiâ€ will rule the world.

Thatâ€™s not necessarily a bad outcome: in fact, with consumer demand from heavily indebted developed economies in the US and Europe fated to slacken for the foreseeable future, a faster appreciation of the yuan might be just the catalyst for a global rebalancing thatâ€™s desperately needed. It could also be the recipe for taming inflation in China, which has risen over the past year to the point where worries about social unrest abound.

Yet, thereâ€™s something about the yuan appreciation story thatâ€™s bringing out the hyperbolic best in commentators. Itâ€™s true that the pace of appreciation has been faster than the glacial pace weâ€™re used to seeing. And itâ€™s also true that this in contrast to 2008, when in response to the global financial crisis, China returned the yuan to its dollar peg.

Although the outlook on the global economy is getting distinctly cloudy today, the mere fact that Chinese authorities havenâ€™t reflexively returned to the dollar peg, but have allowed a faster-than-usual appreciation of the yuan reflects perhaps greater confidence in their control of their economy.

In fact, just today, Chinaâ€™s Vice-Premier Li Keqiang, visiting Hong Kong, announced yet more policy measures that, in the opinion of analysts, will gradually take the process of internationalisation of the yuan to the next stage.

And yet, the story about yuanâ€™s prophesied limitless appreciation has several layers of myth-making wrapped around it.

For a start, itâ€™s true that the yuan has appreciated against the US dollar over the past fortnight, and particularly since the debt ceiling deal in the US saw the worst of the politics of brinkmanship in the US very nearly pushing it to the brink of a default on its debt obligations.

Yuanâ€™s rise not uniform across currencies

A growing tribe of moneyed investors are actually betting that the yuan will depreciate against the US dollar. Petar Kujundzic/Reuters
But the yuanâ€™s relative performance against a trade-weighted basket of currencies this year has been far less spectacular: itâ€™s been essentially flat all year. And in fact, since March, the yuan has actually depreciated by about 5.8 percent against the Japanese yen.

Even the news about a widening of the daily trading band and the inference that it will lead to faster yuan appreciation is characterised by the same hyperbole. UBS China economist Wang notes that even â€œa widening of the daily trading bandâ€¦ will not mean more than a modest increase in flexibility.â€ As she points out, even the current trading band has almost never been used to the limit, so the wider band is purely of academic interest.

The other reason thatâ€™s advanced to explain the recent appreciation in the yuan is Chinaâ€™s felt need to diversify away from a depreciating US dollar, which as economists have argued, comes at enormous cost to Chinaâ€™s economy. But as even Chinese officials have acknowledged, most recently today, there isnâ€™t an alternative avenue for China to park its mountain of foreign exchange reserves. As weâ€™ve argued in the past, there isnâ€™t a market big enough and deep enough and safe enough and liquid enough for Chinaâ€™s needs.

In fact, Chinaâ€™s investments in dollar-denominated assets are the monetary equivalent of parking your car in an authorised parking lot: you pay a small price for the safety. Similarly, the losses that central banks are reconciled to booking when the dollar falls in value are like a â€œparking feeâ€: a small price to pay for safety, particularly in terms of great volatility in exchange rates.

Betting on a yuan depreciation

In fact, a growing tribe of moneyed investors are actually betting that the yuan will depreciate against the US dollar. These investors, from hedge funds to wealth management firms, believe that the Chinese governmentâ€™s â€œartificial exchange rate controls and low interest rates have created asset bubbles in areas such as real estate and bank credit, and that a downturn will follow.â€

And even those analysts who believe it will appreciate against the dollar arenâ€™t expecting a sharp appreciation. â€œWe donâ€™t think that the faster (yuan) move last week means that the renminbi will appreciate by more than 5-6% this year,â€ says Wang of UBS.

And if owing to uncertainty about the European economy, the Euro drops substantially against the US dollar â€“ or if Chinaâ€™s exports collapse â€“ she reasons the government will suspend the yuan appreciation â€“ and even let the currency depreciate modestly against the US dollar.

In other words, the yuanâ€™s rise isnâ€™t quite the one-way bet that excitable headline writers make it out to be. In fact, watching grass grow may make for a more engaging pastime in the near term.